Premature Tax Cuts Lead To Debt Blowouts

Premature tax cuts started back in 2005 with Working for Families. That was a tax cut because it is social policy administered by Inland Revenue. This turned a substantial number of net taxpayers into net beneficiaries – they received more in Working For Families payments than they paid in taxes.

When the National government was elected, they did not remove Working For Families tax credits, which had already significantly reduced net government revenue. They then implemented a program of income tax cuts lowering the top rate of tax on income over $70,000 to 33%.

This program of tax cuts was carried out on the basis that it would stimulate the economy and create new jobs. It was even argued that these tax cuts were “revenue neutral”. This has not happened as evidenced by the 13 year high in unemployment and billions of dollars in additional deficit borrowing. Before the massive shock of the Christchurch earthquakes, the government was already on a pathway to higher long term debt.

There are several problems with higher government debt. Reinhart and Rogoff (2011) found that over debt-to-GDP levels of 90% are related to poor economic growth. One key problem for New Zealand is that once a threshold of 60% debt-to-GDP is reached, growth declines by ~2%. New Zealand is currently growing at less than that. Reaching that threshold of debt-to-GDP ratio could conceivably lead to a recession.

Other costs associated with higher government debt include the crowding out effect. There is a limited amount of capital available for New Zealand borrowers. When the government borrows more, the sovereign guarantee means that it is preferable to buy government debt over corporate debt. With the Local Government Authority issuing its own debt, it is even harder for firms to raise capital in the debt markets.

When firms find it harder to raise debt or equity capital, investment is delayed or put off indefinitely. Because investment is a key driver of economy activity and leads to substantial job creation, lower investment is terrible for New Zealand in the long run. There are also major concerns over arguments that a “multiplier effect” exists when the government spends money. The money has to come from somewhere, and we know that each dollar collected in tax costs the economy at least $1.30 according to Treasury analysis.

What if we look at GDP figures for each of these years and figure out how many millions of dollars in additional borrowing has been incurred by the government solely because of Working for Families and the tax cuts program?

At the end of June 2012, sovereign guaranteed debt was equal to $75.7 billion dollars. If we take this $32 billion dollar estimate of net revenue lost because of premature changes in fiscal policy as given, that means almost half of government debt wouldn’t be there if the changes hadn’t been implemented.

Many people who complain about “tax cuts for the rich” have missed is that it’s not just the tax cuts that have reduced net revenue had accelerated budget deficit blowout – it’s a system that produces the absurd marginal tax rates shown here:

While New Zealand has tried to pursue a mixture of deficit spending and cost cutting, the revenue side of the equation has been rundown significantly. Another problem is that the recession is leading a lot of poorly managed businesses to run up massive tax debt that they have no hope in paying.

How much of that will have to be written off? Putting all ideological debate about whether lower taxes are good for growth or not aside, the National government is refusing to take steps to shore up the financial position of the government.

They are setting up the framework for a Greece-style situation to happen in New Zealand. A rising population, meagre national wealth, high overseas debt and tax revenue falling further as emigration rises will all combine to create a catastrophic debt crisis in 10-15 years time.

Any attempt to smooth over the debt figures with talk of “net debt” is PR spin. In order for “net debt” to hold, the debt must be rolled over continually or new debt issued continually.

The moment that does not happen, the “net revenue loss creep” from 2005 to whenever that happens will number in the tens of billions of dollars. And for what?

The sickness in the New Zealand economy hasn’t suddenly reversed itself with the lowering of the top tax rate and creating perverse incentives for people who qualify for Working For Families.